Lecture 1 – Corporate Governance
What is corporate governance?
- Deals with the relationships among various participants in determining the directions
and performance of corporations
- The system by which companies are directed and controlled
- Deals with the ways in which suppliers of finance to corporations assure themselves of
getting a return on their investment
- What corporate governance is not:
o Not about management, but about the control and direction of managers
o Not just regulation/code
o Not a faith/belief
Why corporate governance?
- Better corporate performance, economic efficiency and social welfare
- Ensure good decision making: good management, good investments
- Create checks & balances and prevent abuse of power
- Diminish corporate failures & scandals
- Better access to finance, lower cost of capital
How does governance take place – Corporate governance mechanisms
- Internal (firm-oriented)
o Ownership structure
o Board structure
o Compensation structure
- External (market-oriented)
o Capital market / Analysts, Auditors
o Takeover market
o Debt market / Creditors
o Product market / Competitors
o Labor market
o Regulation
- In addition to these formal mechanisms, some informal governance mechanisms also
exist:
o Codes
o Social norms
o Reputation & trust
Theories related to corporate governance
- Agency Theory
1
, o Organizations are characterized by one party, the principal, delegating work to
another party, the agent
o In context of a corporation:
Owners (principal) hire managers (agent) to run the firm in exchange for
an agreed compensation
o Parties join to do business but have conflicting interests: potential risk of
managers acting in their own interest at the expense of the owners
Agency problems arise
o Conflict of interest becomes important because only one party bears the cost
o Owners therefore need to:
Monitor the managers
Find ways to align interests
o Since a corporation has stakeholders other than just owners and managers,
different types of agency problems arise
- Information asymmetry theory
o Agency theory cannot alone explain human behavior
o Owners and managers experience asymmetric information between them
o It creates two types of information problems:
Adverse selection (i.e. hidden knowledge)
Owner know less about the capabilities of a manager who knows
herself more
Occurs before the principal takes the decision, i.e. employ the
manager wrong managers might be selected
Partly solved through screening or monitoring incoming applicants
Moral hazard (i.e. hidden action)
Activity of managers cannot be observed by owners
Occurs after the decision, i.e. manager is employed
Managers can be given incentives to share some of shareholders
risks
- Stakeholder theory
o Takes account of a wider group of constituents rather than focusing on
shareholders
Focus usually on shareholders based on interest in resources being used
to maximum effect; should benefit society as a whole
o Stakeholder – any individual or group on which the activities of the company
have an impact unclear protection of their rights
o Shareholder – entity that owns shares in a company rights protected by law
Can be part of the stakeholders
o Stakeholders (apart from shareholders) include:
Employees
Interest in company – provide their livelihood
Concerned with pay/working conditions
Customers
2
What is corporate governance?
- Deals with the relationships among various participants in determining the directions
and performance of corporations
- The system by which companies are directed and controlled
- Deals with the ways in which suppliers of finance to corporations assure themselves of
getting a return on their investment
- What corporate governance is not:
o Not about management, but about the control and direction of managers
o Not just regulation/code
o Not a faith/belief
Why corporate governance?
- Better corporate performance, economic efficiency and social welfare
- Ensure good decision making: good management, good investments
- Create checks & balances and prevent abuse of power
- Diminish corporate failures & scandals
- Better access to finance, lower cost of capital
How does governance take place – Corporate governance mechanisms
- Internal (firm-oriented)
o Ownership structure
o Board structure
o Compensation structure
- External (market-oriented)
o Capital market / Analysts, Auditors
o Takeover market
o Debt market / Creditors
o Product market / Competitors
o Labor market
o Regulation
- In addition to these formal mechanisms, some informal governance mechanisms also
exist:
o Codes
o Social norms
o Reputation & trust
Theories related to corporate governance
- Agency Theory
1
, o Organizations are characterized by one party, the principal, delegating work to
another party, the agent
o In context of a corporation:
Owners (principal) hire managers (agent) to run the firm in exchange for
an agreed compensation
o Parties join to do business but have conflicting interests: potential risk of
managers acting in their own interest at the expense of the owners
Agency problems arise
o Conflict of interest becomes important because only one party bears the cost
o Owners therefore need to:
Monitor the managers
Find ways to align interests
o Since a corporation has stakeholders other than just owners and managers,
different types of agency problems arise
- Information asymmetry theory
o Agency theory cannot alone explain human behavior
o Owners and managers experience asymmetric information between them
o It creates two types of information problems:
Adverse selection (i.e. hidden knowledge)
Owner know less about the capabilities of a manager who knows
herself more
Occurs before the principal takes the decision, i.e. employ the
manager wrong managers might be selected
Partly solved through screening or monitoring incoming applicants
Moral hazard (i.e. hidden action)
Activity of managers cannot be observed by owners
Occurs after the decision, i.e. manager is employed
Managers can be given incentives to share some of shareholders
risks
- Stakeholder theory
o Takes account of a wider group of constituents rather than focusing on
shareholders
Focus usually on shareholders based on interest in resources being used
to maximum effect; should benefit society as a whole
o Stakeholder – any individual or group on which the activities of the company
have an impact unclear protection of their rights
o Shareholder – entity that owns shares in a company rights protected by law
Can be part of the stakeholders
o Stakeholders (apart from shareholders) include:
Employees
Interest in company – provide their livelihood
Concerned with pay/working conditions
Customers
2
